Who said Bonds were Boring?

I’ve written pretty extensively over the last few posts about how yields have risen precipitously over the last couple of years across the curve.

Take a look at the current yield curve versus where it was in the midst of the covid despair, when the entire curve was yielding sub 1% - even as far out as 30 years. Contrast that with the current environment, where 1 month Treasury bonds are yielding in excess of 5.5%. Yields that haven’t been seen since the GFC.

Fixed Income was in a major 30+ year Bull market from when Paul Volcker to the Fed Funds rate to north of 20% in 1981 all the way through to when Janet Yellen began raising rates in 2015. This was a lucrative time to be a Fixed Income investor – remember the inverse relationship between bond prices and bond yields.

As a quick reminder as to why this relationship exists- lets say I buy a 10 year US Treasury bond for $100 at the prevailing rate of 5%. And lets assume, that as soon as I press that buy button, interest rates goes up by 1%. Any newly issued bond (as well as deposits) will now pay investors a higher rate than my existing bond. Hence, all else being equal, the value of my existing bond will fall to compensate, and my bond will trade at a discount. Conversely, if prevailing market interest rates fall, bonds that have already been issued will continue to pay the same coupon rate as they did previously, a rate that was based on a higher interest rate when they were issued. The older bonds are more attractive, and the value will rise accordingly.

The underlying concept is known as arbitrage. In the above example, there was no difference between the bond I was holding and the newly issued bond available in the market, except for the higher coupon rate. If the price of the bonds remained the same, then someone could come in, purchase the bond with the higher coupon and short sell the bond with the lower coupon, and generate a “free” income stream. Markets love a good old arbitrage, and if an opportunity is spotted, just as quickly as the opportunity presents itself, it is quickly wiped away, as market participants rush in to exploit the opportunity. Hence the price falls until the 2 bonds trade at the same Yield to Maturity. This is due to the fact that there will be a “pull to par effect” as the bond matures. EG in the above example, where I am getting an annual coupon of 5, and then prevailing market interest rates goes down to 4%. The price of my bond will go up, as my higher coupon rate is more valuable, though ultimately will lose in value, as the bond has a pre-defined payout stream, and at maturity will only pay out $100 principle. Hence although my coupon yield may be 5%, the effective yield which accounts for the loss of value over time is 4%, which is identical to all other Treasuries maturing in 10 years.

One of the benefits of investing in Bonds, is that you are fully aware at the time of purchase what the overall return will be over the lifetime of the bond, obviously assuming the bond doesn’t default. Obviously in the interim period, prior to the maturity of the bond, the price of the bond fluctuates due to:

·???????? Changes prevailing interest rates (as discussed)

·???????? The pull to par effect (as discussed, whereby all else equal, the pull to par effect will be greatest the closer the bond gets to maturity

·???????? Changes in credit ratings assigned by rating agencies

·???????? as well as general market conditions, eg during periods of equity market correction will tend to see a higher investor demand for the safety of bonds

However, on the assumption that the bond is held to maturity (and doesn’t default), then as all the cash flows are known, and the face value at maturity is known, then the interim price fluctuations are not relevant, and the Yield to maturity is known at the time of purchase. Meaning, that at the time of purchasing the bond, you know full well what yield you will be getting throughout the lifetime of the bond.

So if bond yields and prices move in the opposite direction, and we have just experienced the most aggressive tightening cycle in decades, presumably then mark to market losses on bonds held are calamitous!

In a word …. Pretty much! Although it very much depends upon the tenure of the bond. In a rising rate environment, the longer the duration of the bond, the worse the mark to market losses. This can be clearly seen by looking at the performance of the following ETF’s (Total return, taking dividends/coupon payments into consideration:

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SHY: iShares 1-3 Year Treasury Bond ETF: -1.28%

IEI: iShares 3-7 Year Treasury Bond ETF:-9.08%

IEF: iShares 7-10 Year Treasury Bond ETF: -16.66%

TLT: iShares 20 Year Treasury Bond ETF -35.59%

ZROZ: PIMCO 25+ Year Zero Coupon U.S. Treasury Fund ETF: -49.93%

However, it is not all gloom and doom. If one assumes that the bulk of the rate rises are behind us, even if rates do continue to go higher, the ensuing mark to market losses are likely to be far tamer than those experienced thus far. Even though longer dated bonds have continued their negative performance 2023 YTD (TLT is down 4.5% YTD), the 2022 bond market rout has actually paved the way for a more likely stronger performance going forward, even if it may take a little more time for the returns to start coming through.

If rates are very low to begin with, the impact of rising rates on bond returns will be much larger, because the starting yield provides less of a buffer, and the change in relative terms is much larger. A 1% change in interest rates going from 1% to 2% (and the ensuing price decline) is much larger than a 1% change from 4% to 5%. The environment in which we find ourselves today, where rates have risen to yields that are more akin to historical norms, means that the higher yield being earnt serves as an extra cushion from price deterioration, even if rates continues to rise.

The other piece of good news that Bond Investors should take heart in, is that historically there has been a very high correlation between the starting yields of a bond/index and subsequent future returns. The correlation is fairly weak on a 1 year forward basis, but increasing the time horizon to 3 years, and already the starting yield is a fairly good proxy for future returns.

If you can increase the horizon to 5 years, then that relationship has historically been very tight, and with starting yields at their highest level since 2008, the return profile looks compelling.

With bond yields at the highest on offer for decades, it is no wonder that there has been an almost unsatiable demand for bond funds. In fact, YTD, inflows to money market funds have dwarfed inflows to any other asset class. And for good reason. No more low interest rates. For years savers were starved of yield, being forced into increasingly risky lower quality junk bonds in order to earn a decent yield, and all of a sudden opportunities are aplenty. Higher yields are available on far “safer” Government bonds and Corporate credit. ?

What is not clear from the above chart, is where all of this cash is coming from. Have investors been de-risking their portfolios by selling equities? Or have investors become more mindful following the SVB debacle and have moved excess cash into short term securities? Either way, with the yield curve downward sloping, and the highest rates on offer at the shortest end of the curve, this has not? been a surprising dynamic.

The downward sloping yield curve means that investors can earn the highest yield at the shorter end of the curve. However, they face more reinvestment risk, as although very short dated bonds are highly attractive, if and when the economy does enter a recession, which presumably it will do at some stage, then the Fed will likely be forced into lowering rates again, and you may find yourself having to reinvest your capital at lower yields.

Its not only nominal bonds whereby yields are as high as they have been in decades. Even TIPS are yielding a REAL 1.9% yield, that’s 1.9% over and above inflation.

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Bottom line, is that after years and years of there being almost no option to earn anything remotely resembling a decent yield, there are now options irrespective of ones outlook going forward.

If you are worried about another major inflation outbreak, you can earn a nice 2% yield plus inflation. If you’re worried about deflation, recession or the Fed lowering interest rates, then you would want to be extending duration and have the opportunity in longer dated bonds. And if you are worried about continued rate rises, then the highest yield currently on offer is in the shortest dated bonds.

Whoever said bonds were boring?!!!

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Dani Schijveschuurder is an investment advisor that provides advice regarding the financial vehicles mentioned in the article. The views and opinions of the writer are his own and do not represent the views or opinions of the Goldrock Partners or its affiliates.